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Book Value and Intrinsic Value

Warren Buffett considers intrinsic value as the only logical way to evaluate the relative attractiveness of investments and businesses. It is defined as the discounted value of cash that can taken out of a business during its remaining life.

This value is highly subjective as it depends on estimations of future cash flows and changing interest rates.

An example of college education is used by Warren to illustrate the possible divergence from book value and intrinsic value.

First, let’s treat the cost of education as it’s “book value”.

Then, we must estimate the earnings that will be earned by the graduate over his lifetime and subtract what he would have earned if he didn’t have his college education.

This excess earnings should then be discounted back to graduation day using an appropriate interest rate. The final value represents the intrinsic value of the college education.

Some graduates may calculate that the book value of their education exceeds the intrinsic value, which meant they overpaid. Other graduates may calculate and find the converse, which meant that capital was wisely deployed.

No matter what, it is clear that book value does not figure as a calculation for intrinsic value.

Now, let’s look at a real life Berkshire example.

Scott Fetzer was bought by Berkshire at the beginning of 1986 for $315.2 million, which at the time of purchase had $172.6 million of book value. A premium of $142.6 million was paid as Warren Buffett believed the intrinsic value of the company was close to 2 times the book value.

This premium would have to be written-off against earnings annually as shown in the table below:

                 Beginning     Purchase-Premium      Ending
Purchase Charge to Purchase
Year Premium Berkshire Earnings Premium

---- --------- ------------------ --------
(In $ Millions)

1986 ........... $142.6 $ 11.6 $131.0
1987 ........... 131.0 7.1 123.9
1988 ........... 123.9 7.9 115.9
1989 ........... 115.9 7.0 108.9
1990 ........... 108.9 7.1 101.9
1991 ........... 101.9 6.9 95.0
1992 ........... 95.0 7.7 87.2
1993 ........... 87.2 28.1 59.1
1994 ........... 59.1 4.9 54.2

By the end of 1994, the premium had been reduced to $54.2 million.

The change in book value, earnings and dividends of Scott Fetzer over the years is as follows:

                  (1)                                 (4)
Beginning (2) (3) Ending
Year Book Value Earnings Dividends Book Value

---- ---------- -------- --------- ----------
(In $ Millions) (1)+(2)-(3)

1986 .......... $172.6 $ 40.3 $125.0 $ 87.9
1987 .......... 87.9 48.6 41.0 95.5
1988 .......... 95.5 58.0 35.0 118.6
1989 .......... 118.6 58.5 71.5 105.5
1990 .......... 105.5 61.3 33.5 133.3
1991 .......... 133.3 61.4 74.0 120.7
1992 .......... 120.7 70.5 80.0 111.2
1993 .......... 111.2 77.5 98.0 90.7
1994 .......... 90.7 79.3 76.0 94.0

Despite the book value remaining fairly constant, the earnings showed a steady increase. Consequently, the return on equity became extraordinary.

If you look at the carrying cost of Scott Fetzer on Berkshire’s books at the end of 1994, it has already been reduced to $148.2 million (54.2+94).

This amount is less than half their carrying cost at the point of purchase, yet the earnings was twice of what it was then.

This meant that the difference between Scott Fetzer’s intrinsic value and the carrying cost on Berkshire’s books has grown to quite huge at the end of 1994.

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Book Value, Intrinsic Value & Market Value

Let’s look at these 3 terms which are discussed at the start of this letter.

Book value is just an accounting term that measures the capital (including retained earnings) that has been put into a business.

Intrinsic value is the present-value of the cash that can be taken out of the business during it’s remaining lifespan. As there is no way we can know the performance of a company in the future, therefore this value has to be estimated.

Market value is simply a price of the share of the company that is quoted on the stock exchange.

Intrinsic value is usually unrelated to book value. Berkshire is an exception and while the two values are different, the book value can be used as a device for tracking the progress of the intrinsic value.

In the long run, the market price and intrinsic value of a company will arrive at about the same price but in the short term, these two prices could be significantly different.

As an example, Berkshire’s book value and intrinsic value both grew by about 14% in 1993, while the market value grew by 39%.

Having said that, Warren Buffett still views Berkshire’s market price as appropriate if (a very big IF) they can continue to meet Berkshire’s long term goal of increasing their intrinsic value at an average annual rate of 15% (in a world of 6-7% long term interest rates). With an ever increasing capital base, this target is getting more and more difficult to meet.

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In the past year, there was an increase in the number of registered shareholders (due to the merger with Blue Chip Stamps) from 1900 to 2900. As such, Warren started this year’s letter with a summary of his key principles:

1) Shareholders are treated as owner-partners; Warren and Charlie Munger are simply managing partners. The company is simply a conduit through which shareholders own the assets of the business.

2) Company directors are all major shareholders of Berkshire Hathaway.

3) The long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. This is not measured by the size but more on per-share basis.

4) The preference for achieving point three above is by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by insurance subsidiaries.

5) Consolidated reported earnings may reveal relatively little about the true economic performance due to accounting rules.

6) Warren would rather prefer to purchase $2 of earnings that is not reportable under standard accounting principles than to purchase $1 of earnings that is reportable. Capital-allocation decisions are not influenced by accounting rules.

7) To prevent over-leverage, debt is seldom used.

8) A managerial “wish list” will not be filled at shareholder expense.

9) Common stock will be issued only when business value received is as much as the one given.

10) Regardless of price, Warren has no interest in selling any good businesses that Berkshire owns, and is very reluctant to sell sub-par businesses as long as he expects them to generate at least some cash and as long as he feels good about their managers and labor relations.

11) Investment ideas will normally not be discussed as good ideas are hard to come by.

Nebraska Furniture Mart

The letter goes on to highlight the main point of 1983; the acquisition of a majority interest in Nebraska Furniture Mart and the resulting association with Rose Blumkin and her family.

Rose started the business with $500 of her savings (after having arrived in USA with no money and no knowledge of English many years earlier) and grew it to over $100 million of sales annually out of one 200,000 square-foot store. One question that Warren always ask himself in appraising a business is how he would like, assuming he had ample capital and skilled personnel, to compete with it.

In his own words, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.”

Book Value Vs Intrinsic Value

In the past year, the book value of Berkshire increased by 32%. Warren never takes the one-year figure very seriously. Why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Rather, a five year yard stick should be used.

While performance is usually reported in book value, the one that really counts is intrinsic business value. Book value only serves as a conservative but reasonably adequate proxy for growth in intrinsic business value.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

Using a simple analogy, assume you spend identical amount of money putting two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education.

Similarly, businesses having equal financial input may end up with wide variations in value.

Stock Splits

One of Warren goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. The key to a rational stock price is rational shareholders, both current and future owners.

High quality shareholders can be attracted and maintained if there is consistent communication of the business and ownership philosophy – along with no other conflicting messages.

With a stock split or some other actions focusing on stock price rather than business value, an entering class of buyers inferior to the exiting class of sellers would be attracted.

Would a potential one-share purchaser be better off if the shares were split 100 for 1 so he could buy 100 shares?

Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of the present shareholder group.

Thus, Warren will avoid policies that attract buyers with a short-term focus on the stock price and try to follow policies that attract informed long-term investors focusing on business values.


Another thing that Warren frowns on is the emphasis on the liquidity of a stock by brokers. A high turnover in shares simply means that the ownership is changing. And the more of this ‘musical chairs’, the higher the commissions will be paid to the stock brokers out of the pockets of investors.

In my next post, I will cover economic and accounting goodwill that was discussed as an appendix to this year’s letter.

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